Because he is a student of history and human nature, Seth Klarman (Trades, Portfolio)’s commentary on value investing contains certain themes that he believes are endemic to investor behavior during sudden market downturns. For Klarman, it is almost axiomatic that those investors who are not committed to a long-term investment regimen are the first to panic during market declines, leading to irrational behavior that frequently causes large losses.
Klarman fervently believes that an essential component of value investing is to adopt, when appropriate and propitious, a contrarian approach towards investing. Following the herd for Klarman and other disciples of Benjamin Graham is anathema for pursuing a diligent, defensive, long-term investing strategy.
In his book, “Margin of Safety,” Klarman illustrated how astute investors can profit from the folly of those whose investment decisions are often based on emotion rather than dispassionate and rational analysis. The guru is unsparing in his description of this class of investors, whose primary motivation is fear and greed:
“Unsuccessful investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear. We all know people who act responsibly and deliberately most of the time but go berserk when investing money. It may take them many months, even years, of hard work and disciplined saving to accumulate the money but only a few minutes to invest it.”
Many investors fail to take the time to investigate the companies they are interested in purchasing. Instead, they buy on impulse or a false sense of security. While many of these same individuals would exercise due diligence prior to purchasing an electronic device or a toaster, few can be bothered to conduct the most rudimentary analysis of a stock listed on one of the various exchanges. Klarman wrote:
“The same people would read several consumer publications and visit numerous stores before purchasing a stereo or camera yet spend little or no time investigating the stock they just heard about from a friend. Rationality that is applied to the purchase of electronic or photographic equipment is absent when it comes to investing.”
For many investors, the stock market is not an environment for purchasing a business at a fair price, hopefully below its intrinsic value, but rather on opportunity to make quick money without the slightest bit of exertion devoted to the most elemental analysis of the company whose shares are being purchased. Klarman said:
“Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return. Anyone would enjoy a quick and easy profit, and the prospect of an effortless gain incites greed in investors. Greed leads many investors to seek shortcuts to investment success. Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips.”
Klarman suggests that human nature can lead to a speculative froth or a “new era” of investment thinking, which dispenses with patient detachment, attendant to traditional and rational analysis, in favor of satisfying individuals appetite for greed and avarice:
“High levels of greed sometimes cause new-era thinking to be introduced by market participants to justify buying or holding overvalued securities. Reasons are given as to why this time is different from anything that came before. As the truth is stretched, investor behavior is carried to an extreme. Conservative assumptions are revisited and revised in order to justify ever higher prices, and a mania can ensue.”
Since the voice of reason falls upon deaf ears, for those euphoric investors engaged in speculation, implementing a defensive strategy based on the margin of safety principle is difficult, if not impossible. He said:
“In the short run resisting the mania is not only psychologically but also financially difficult as the participants make a lot of money, at least on paper. Then, predictably, the mania reaches a peak, is recognized for what it is, reverses course, and turns into a selling panic. Greed gives way to fear, and investor losses can be enormous.”
Klarman undoubtedly would encourage intelligent investors to heed the advice famously offered by Warren Buffett (Trades, Portfolio): “Be greedy when others are fearful, and fearful when others are greedy.